A Range of Strategies
Within the options market, a broad range of strategies can be employed to control risk, enhance profits, or to create combinations between stock and options or between related option contracts.
The range of strategies can be distinguished as bullish, bearish, or neutral. A bullish strategy produces profits if the price of the underlying stock rises. A bearish strategy becomes profitable when the stock price falls. And a neutral strategy does best when the underlying stock’s price remains within a narrow price range. The types of strategies can also be broken down into a few broad classifications, as follows:
Single-option speculative strategies. The speculator uses options simply as an estimation of how the underlying stock price is going to move in the future and leverages that movement. This means the option cost is far lower than the cost of buying 100 shares; so, a portfolio of speculative options controls far more stock than trading in the stock itself. Long option positions benefit when the price of the stock rises (for long calls) or falls (for long puts). Short speculative strategies, also called uncovered or naked writes, assume higher risk positions. Although the holder of a long position will never lose more than the cost of opening the position, naked short selling includes potentially higher risks. A naked call writer has potentially unlimited risk based on the possibility that a stock’s price could rise indefinitely. A naked put writer faces a downside risk; if the stock value falls, the put will be exercised at the fixed strike price, and the writer will be required to buy shares at a price above market value.
Speculative strategies serve a purpose in many circumstances and can be efficiently used for swing trading. This is an approach to the market in which trades are timed to the top or bottom of short-term price swings. Rather than using shares of stock for swing trading, using long options provides three major advantages. First, it requires less capital, so a swing trading strategy can be expanded. Second, risk is limited to the cost of the long option, which is significantly lower than buying or selling shares of stock. Third, using long puts at the top of a short-term price range is easier and less risky than shorting stock.
Single options are also used to insure other positions. For example, traders may buy one put to protect current paper profits in 100 shares of long stock. They might also buy calls to mitigate the risks of being short on stock. Insurance of other positions, or hedging those positions, has become one of the most important ways to manage portfolio risk.
- Covered calls. The most conservative options strategy is the covered call. When a trader owns 100 shares of the underlying stock and sells a call, the market risk faced by the naked writer is eliminated. If the call is exercised, the writer is required to deliver those 100 shares of stock at the strike price. Although the market value at that time will be higher, the covered call writer received a premium and continues earning dividends until the position is exercised, closed, or expired. A variation of covered call writing that varies the risk level is the ratio write. This strategy involves selling more calls than full coverage allows. For example, a trader who owns 200 shares and sells three calls has entered a 3:2 ratio write.
- Spreads. The spread involves buying or selling options at different strikes, with different expirations, or both, on the same underlying stock. Variations include calendar, butterfly, ratio, and reverse spreads. These are among the most popular of options strategies because profits and losses can be controlled and limited in the structure of the spread.
- Straddles. The straddle involves buying or selling dissimilar options with the same strike prices and on the same underlying stock. Risks might be greater, and creating profits is often more difficult than with spreads, but many variations make straddles interesting and appealing. Because one of the two sides can be closed profitably at any time, straddle risks can be reduced over time, especially for short positions or for the strangle, a variety of straddle.
- Combinations. Some strategies involve the combined positions in options with related positions in other options, often with weight favoring bullish or bearish movement in the underlying stock. Any position with both calls and puts that is not a straddle is classified as a combination.
- Synthetic positions. Some strategies are designed to create profit and risk profiles equal to other positions; these are called synthetics. For example, opening a long call and a short put creates synthetic long stock (an options position whose price will react in the same way as buying 100 shares of stock). A long put with a short call creates the opposite: synthetic short stock. The appeal to synthetic positions is that they can be opened for less capital than the mirrored position and often with identical or lower risk.
Anyone embarking on the use of options in their portfolio needs to appreciate the various levels of risk to a particular strategy as a primary consideration. The next chapter explains how risk varies among the different options strategies.